CHG Issue #148: Unpacking Investment Vehicles

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The number of publicly traded companies has declined from 7,000 at the turn of the century to less than 4,000 today.? While the number of companies listing their shares on public exchanges has decreased there has been a proliferation of managed investment vehicles. Managers have expanded the functionality of the capital markets by reducing the complexity around market access and strategies but in doing so they have introduced new complexities that require careful consideration.

Investment vehicles are designed increase financial intermediation by transforming complex things to make them 1) more marketable or 2) more functional. The marketability of an investment should clear but the meaning of functionality requires a bit more explanation. Simply stated, the common goal of investing is to grow wealth over a period of time to fulfill some future obligation. It is beyond our scope to consider the wide variety of those future obligations but for our purposes we can consider them liabilities and investors are matching current assets with future liabilities.

Before we move on we must distinguish between two types of investment vehicles: direct and indirect. Direct vehicles can include the increasingly scarce publicly traded shares or shares in private corporations, limited partnership interests, loans, real estate, commodities, precious metals, or cryptocurrencies. Indirect vehicles can include ETFs, hedge funds, mutual funds, private equity funds, venture capital funds, futures, or options. The primary difference is that indirect vehicles provide access to investments by introducing an intermediate structure such as a fund or a derivative contract. It should also be noted the overlap of the two and how easy it is to confound the asset class with the vehicle.

To understand how investment vehicles increase the functionality of the capital markets think of what happens behind the scenes in your computer when you click your mouse on a website link. All the graphics, networking, routing, and file operations that take place when you click a link had to be done manually in the early days of the internet, but programmers took that complex process and reduced it into a single mouse click. The functionality of the internet increased dramatically, but the complexity of it remains. The difference is more people can use it but fewer people really know how it works, or know what to do when that functionality breaks down. Therefore, we end up trading agency for increased functionality by utilizing these vehicles.

We give up personal agency to financial advisors and managers of all shapes and sizes so that we can feel more confident in making more investments to meet the imperative of growing our wealth. We realize that individually we are at a disadvantage in the highly competitive financial markets so we naturally seek the help of so-called experts. This is a logical reaction but it puts us in a vulnerable position to more knowledgeable and powerful people which results in many challenges but one that may be familiar is the principle-agent problem.

The heart of the principal-agent problem is a misalignment of incentives. The principal seeks actions that maximize their own welfare while the agent may have personal goals that diverge from the principal's. Investment managers get paid a management fee on the assets they manage but this structure creates an incentive for the manager to focus on growing assets under management instead of providing the best management services possible. Incentive fees are widely used to better align manager and investor interests but these are an imperfect solution.

There are different ways to structure and pay incentive fees. Within private equity there is typically a 1-2% management fee and then a 20% incentive fee for all profits above some preferred return. However, there are different ways to pay this incentive fee which create all sorts of interesting conflicts. The European Waterfall is the most common method used, and it simply applies the preferred return and incentive fee on the entire pool of investments that the manager is managing. This seems like a logical approach, however what can happen in these situations is the manager may make a series of bad investments or just get unlucky and set the fund back to a point where the probability of getting paid the incentive fee is low. If they are managing multiple funds it makes sense for that manager to focus their energy on the funds that have a better probability of paying an incentive fee. Taking this one step further you can see how it further motivates the manager to raise more funds so they have as many options to earn the incentive fee as possible. The incentive fee is essentially a call option on your investments that has been given to the manager for free, and accordingly the manager is going to focus on trying to accumulate as many free options as possible.

An alternative method is the American Waterfall where the preferred return and incentive fee are applied to each individual investment in the fund separately. In this case the manager will still be trying to accumulate free options, but they will also be trying to pick individual investments that have a higher probability of putting that option in the money. Even if they make a few bad calls or run into some bad luck, the manager will still be incented to make money for the client. However, in this case the total incentive fee that gets paid to the manager is going to be higher than it would otherwise because the manager has no risk of loss. If the manager makes ten investments and only 1 pays off and the fund losses money, the manager will still earn an incentive fee. Where the European Waterfall succeeds in aligning interests the American Waterfall fails and vice versa. Neither is a perfect option.

When investing in certain asset classes like real estate investors may not hire a manager to make the investing decision for them, but only to manage the investment once the decision is made. Strangely, you will find many of the same incentive fee structures in these sorts of vehicles even though the work the manager is doing less work. In these cases the investors want to be able to look at investments on a deal by deal basis and make the decision themselves, but are unable to manage the investment beyond that initial decision. There is a good argument to be made about the wisdom of such an approach because the manager is theoretically the expert and better equipped to make such a decision. Although, in these cases the manager is often providing the investor with access to unique investment opportunities and the investor is happy to pay the incentive fee for what is essentially a sourcing function.

The best rationale for investing on a deal-by-deal basis is found by viewing pooled vehicles from a different perspective. In most cases, when an investor is considering investing in a private equity fund or hedge fund, the fund itself is what is known as a blind pool. That means the investor is only investing in an idea or a strategy because none of the investments have been made yet. This applies, to a lesser extent, to mutual funds and some actively managed ETFs where you can look at an existing portfolio, but you don't know what the future portfolio will look like because the manager has discretion to make changes. In these cases you are investing in the manager more than you are investing in the asset class. You are investing in an abstract idea, and it is not easy to do well, which explains the popularity of passive investment vehicles these days.

Investing in a known asset or portfolio is far less complex than investing in a manager. Managers point to their track record and limit the range of things they can do in certain vehicles to limit some of the risk of the blind pool uncertainty, but there is a natural tension between limiting the uncertainty and restricting the ability of the manager to succeed. Managers and asset classes are frequently confounded with good managers in bad asset classes struggling to raise money, while poor managers in good asset classes find money dropped in their lap. Good managers who can provide persistent returns are very rare and hard to find because the financial markets are extremely competitive and everyone is competing for edge which naturally makes it scarce. If you look at the small sample of great managers and try to determine common features or preconditions that you can use to predict the next great managers you will come up lacking.

A common consideration here is the optionality inherent in these different vehicles. We demonstrated how incentive fees are call options, and blind pools are different kind of option. When you invest in a blind pool the manager is long an option on the field of available investment alternatives. Put another way, when you invest on a deal-by-deal basis you are long the thing you bought and short the field. This may not be the case financially, but it is psychologically and we know all too well that psychological capital is just as valuable, if not more valuable, than financial capital.

It is important to distinguish the investment vehicle from the underlying investment because of all the added optionality the vehicle introduces. Vehicles are commonly used to provide access to different asset classes and strategies and they add important characteristics to those investments based on their structure. Take private equity for example, it provides access to companies not listed on stock exchanges and they have a distinct fee structure and term to the investment. When you buy public equities it is a perpetual vehicle, but private equity has a finite life. There is also a strategy component layered onto private equity where the managers typically increase the leverage utilized by the companies they buy.

By unpacking the different features of these vehicles and strategies distinct from the underlying investment we get a better sense of the true nature of the whole investment and can also identify which components we prefer and which we may want to diversify or hedge as consumers. As producers we can deploy these structures to our advantage with an example being the use of Right of First Refusal (ROFR) clauses. As a lender, when borrowers look for capital they are focused on their present needs and tend to undervalue their futures needs. By negotiating a ROFR for future lending opportunities lenders can gain preferential access to profitable deal flow which is a vital requirement for scaling profitable operations. The borrower and the lender have different value considerations, just like fund managers and their investors, and the ROFR clause provides a mechanism for that differential to be realized efficiently. Complexity can be transformed in innovative ways to improve value and increase functionality without exacerbating the principle-agent problem.

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